When Can an Immigrant and Her Claimed Step-Up in Tax Foundation Be Separated on the U.S. Border?

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Alan S. Lederman

Some non-citizen immigrants own a foreign holding company that is classified as a corporation for U.S. tax purposes when they decide to immigrate to the U.S. Suppose that such a foreign holding company holds appreciated assets. It may be undesirable for that corporation to sell these assets to unrelated buyers before the non-citizen immigrates to the U.S. For example, the foreign holding corporation may own interests in closely held businesses that the U.S. immigrant wishes to retain following her U.S. immigration.

Actual Liquidation of a Pre-Existing Holding Corporation

In that situation, a U.S. income tax planning step routinely considered by the non-citizen is to actually liquidate the foreign holding corporation prior to her U.S. immigration. Under the general rule of Section 334(a), upon the Section 331 liquidation of a corporation, an individual stockholder receives a step-up in U.S. tax basis of the liquidated corporation’s assets to the assets’ date-of-liquidation value. The application of a Section 334(a) step-up would eliminate the non-citizen’s post-immigration U.S. income tax on pre-immigration appreciation in the foreign holding corporation’s former assets.

The foreign holding corporation will recognize gain upon its liquidation under Section 336(a). However, if the corporate gain is not effectively connected income, there is no U.S. corporate level tax on such Section 336(a) gain. Similarly, if the stockholder is not yet a U.S. person, there is generally no U.S. tax consequence to that stockholder by reason of a subpart F income or GILTI pass-through on such Section 336(a) corporate gain, nor on her individual Section 331 gain on liquidation.

Check-the-Box Liquidation of a Pre-Existing Holding Corporation

Suppose the foreign holding company that is owned by the non-citizen before she decides to immigrate to the U.S. is not classified as a per-se corporation by Treasury Regulation Section 301.7701-2(b), but rather is classified as a foreign corporation by default under Treas. Reg. Section 301.7701-3(b)(2) because all its members have limited liability. As an alternative to actually liquidating this foreign holding corporation, the non-citizen could consider having that company make a check-the-box election under Treas. Reg. Section 301.7701-3(c)(1), to be treated as a disregarded entity, in connection with her U.S. immigration.

IRS Chief Counsel Memorandum AM 2021-002 deals with a situation where a non-resident non-citizen became a U.S. person while owning stock in a foreign company. The foreign company was not a per-se corporation described in Treas. Reg. Section 301.7701-2(b). Before the non-citizen became a U.S. person, the foreign company’s U.S. tax classification was not yet relevant, and the foreign company had not made any classification elections.

AM 2021-002 concludes that before the non-citizen became a U.S. person, the entity’s classification was determined based on the Treas. Reg. Section 301.7701-3(b)(2) default classification rules. AM 2021-002 further concludes that a valid election to change that default classification, made after the non-citizen became a U.S. person, with a retroactive effective date to the date the non-citizen became a U.S. person, could be made. The substantive tax consequences from the change in classification were deemed to occur the day before the non-citizen became a U.S. person. Although the example in AM 2021-002 deals with an non-citizen becoming a U.S. citizen, while owning a foreign eligible entity whose default classification was a partnership, the principles of AM 2021-002 should apply equally to an non-citizen becoming a U.S. tax resident, while owning a foreign eligible entity whose default classification was a corporation.

Consider again the situation of an non-citizen who indirectly owns appreciated assets through a foreign holding company. Suppose that foreign holding company is not a per-se corporation described in Treas. Reg. Section 301.7701-2(b), but rather is a non-per-se-corporation which is classified as a corporation under the Treas. Reg. Section 301.7701-3(b)(2) default rules because all its members have limited liability. Suppose that shortly after her U.S. residency starting date, she validly elects to have the entity treated as an ignored entity as of her residency starting date.

Under Treas. Reg. Section 301.7701-3(g)(1)(iii), and Dover Corp. v. Commissioner, the effect of the ignored-entity election is that the foreign corporation is deemed to distribute to her, on the day preceding her residency starting date, all of its corporate assets and liabilities in liquidation. Accordingly, upon her immigration to the U.S. she apparently has achieved a step-up in basis of those assets under Section 334(a).

Actual Liquidation of a Transitory Holding Corporation

However, in perhaps most situations, the immigrating non-citizen will directly own appreciated assets, such as interests in closely held businesses, rather than own those assets through a foreign holding company. Suppose the non-citizen, in view of her impending U.S. immigration, transfers these personally owned assets to a newly created wholly owned foreign holding company that is classified by the U.S. tax regulations as a corporation, actually liquidates that corporation, and then immigrates to the U.S. If she sells those assets while she is a U.S. resident, will the IRS concede the Section 334(a) step-up occurred upon the pre-immigration corporate liquidation?

Unfortunately for the immigrant, there are many doctrines the IRS could point to in order to justify the denial of the Section 334(a) step-up. Suppose, in essence, the non-citizen’s plan involves creating a transitory corporation to hold title to the transferred assets and then return the title to the non-citizen. Suppose there was no meaningful purpose for the formation, operation, and liquidation of the foreign holding corporation, other than to achieve the Section 334(a) step-up in tax basis on liquidation.

Doctrines possibly available to the IRS to deny her a Section 334(a) step-up in tax basis on the actual corporate liquidation include the step transaction doctrine, and the lack of economic substance described by Section 7701(o). In Packard v. Commissioner, a husband formed a corporation, and, early in the next calendar year, sold the stock of that corporation to a general partnership of himself and his wife, which partnership then liquidated the corporation. The partnership claimed a Section 334(a) step-up in tax basis for the liquidated corporation’s assets. The U.S. Tax Court applied the step transaction doctrine to ignore the existence of the transitory corporation, thereby denying the partnership any Section 334(a) step-up by reason of the liquidation of that corporation.

Section 7701(o)(1), the clarification of the economic substance doctrine, states that a transaction lacks economic substance unless: (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer‘s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. In Daichman v. Commissioner, taxpayers, a husband and wife, transferred assets to a newly created corporation. The corporation then transferred those assets in exchange for a 98% interest in a family limited partnership controlled by the taxpayer. The taxpayers then, five weeks after the corporation was formed, liquidated that corporation. By heavily discounting the partnership interests, the taxpayers claimed a loss resulting from the corporate liquidation.

The Tax Court applied, to the pre-Section 7701(o)(1) year involved in Daichman, the then-applicable economic substance test of the governing federal circuit, a test that was similar to the test now contained in Section 7701(o)(1). The Tax Court found that the corporate formation and corporate liquidation did not meaningfully change the taxpayers’ economic position, but rather were a meaningless circular flow of assets. The Tax Court further found that there was no genuine non-tax business purpose for forming and liquidating the corporation. Therefore, under the then-governing formulation of the economic substance doctrine, the Tax Court rejected the purported corporate liquidation as a recognition event. In Notice 2010-62, the IRS stated it would rely on pre-Section 7701(o)(1) cases, presumably including Daichman, in applying Section 7701(o)(1).

The Tax Court in Daichman sustained the application of the Section 6662(a) accuracy-related penalty. This suggests that, for current years, the IRS would, in a case similar to Daichman, seek to apply the 20% penalty of Section 6662(b)(6) (or the 40% penalty of Section 6662(i) if disclosure was inadequate). The Section 6662(b)(6) no-fault penalty applies where the deficiency is due to a transaction described in Section 7701(o) or any similar rule of law.

Other doctrines could possibly be applied by the IRS to deny the non-citizen a Section 334(a) step-up. These include the same-year-rescission doctrine, and the denial of allowances generated by tax-motivated corporate acquisitions described in Section 269(a)(1). In Private Letter Ruling 200613027, the IRS treated, at the request of the stockholder, what would otherwise have been a taxable Section 331 liquidation of a corporation that occurred later in the same taxable year as that corporation’s Section 351 formation, as a same-year rescission. This rescission characterization favorably eliminated the stockholder’s gain on the corporate liquidation, but also unfavorably eliminated the stockholder’s Section 334(a) step-up in the liquidated corporation’s assets. However, the scope of the same-year rescission doctrine is somewhat uncertain, and private rulings along the lines of PLR 200613027 are no longer being issued. See Revenue Procedure 2021-3, Section 3.02(8).

There is some doubt whether a Section 334(a) step-up, generated by the liquidation of the acquired corporation, is subject to disallowance under Section 269(a)(1). Compare Supreme Investment Corp. v. United States (Section 334 step-up was not within the scope of Section 269(a)(1) disallowance) with Chief Counsel Notice 2002-003 (Section 334 step-up is within the scope of Section 269(a)(1) disallowance).

However, the application of various substance-over-form and anti-abuse doctrines to a specific fact pattern is often not entirely clear. Doctrines such as step transaction and economic substance have different formulations. Such doctrines are often applied differently in different federal circuits. The relationship between different doctrines is often uncertain, and their application depends on the facts of each case.

The immigrant might argue that there is no abuse from the desired Section 334(a) step-up, and thus no reason for the application of anti-abuse doctrines. After all, if the immigrant had actually sold her personally owned appreciated assets to unrelated parties the day before her residency starting date, generally no U.S. income tax would have been due, and she would receive a new U.S. cost tax basis in whatever assets she bought from the sales proceeds. In IRS Chief Counsel Memorandum AM 2007-006, the IRS, in approving a step-up in basis of foreign assets incident to a Section 338(g) election for a purchased foreign corporate target, noted that such step-up “is not necessarily inappropriate because the appreciation in the Foreign Target’s assets accrued while the Foreign Target was outside of the U.S. taxing jurisdiction. In general, our system permits, but does not oblige, the importation of gain into the U.S. taxing jurisdiction, with the consequences depending on how the taxpayers effectuate their transactions.”

However, the IRS would presumably argue that the non-application of the step transaction, economic substance, and similar doctrines to the transitory foreign corporation is a policy argument that should properly be directed by the immigrant to Congress. That is, the non-resident non-citizen is in effect requesting a stepped-up basis for pre-immigration assets for all federal income tax purposes. By contrast, Congress has provided, in Section 877A(h)(2), that U.S. immigrants receive a step-up in basis of their assets to their residency starting date value; but Section 877A(h)(2) applies only for the limited purposes of computing any subsequent expatriation tax.

Suppose that instead of forming a new transitory corporation to hold her assets, the non-citizen happened to own a pre-existing foreign corporation for many years. She might contribute her appreciated personal assets to that foreign corporation, and then liquidate the foreign corporation or have the foreign corporation make a non-liquidating distribution of such assets. This would eliminate the problem of the corporation being transitory. However, the remaining but quite possibly fatal weak point would be the transitory ownership by that entity of the assets. Notice 2014-58 states that where there is a transfer of assets to an intermediary employed for tax benefits and whose actions or involvement was unnecessary to accomplish an overarching non-tax objective, then the economic substance doctrine may be applied solely with respect to the transfer of those specific assets.

Check-the-box Liquidation of a Transitory Holding Corporation

Consider again the situation of a nonresident non-citizen who directly owns appreciated assets. Suppose the alien, in contemplation of her U.S. immigration, transfers these assets to a newly created wholly owned foreign holding company that is not classified as a per-se corporation by Treas. Reg. Section 301.7701-2(b), but rather is classified a corporation by Treas. Reg. Section 301.7701-3(b)(2) because all the owners have limited liability.

Suppose that, shortly after her U.S. residency starting date, the entity makes a valid check-the-box election to be treated as an ignored entity as of her residency starting date. However, suppose that the non-U.S.-tax legal continuation of the entity to hold the transferred assets has no meaningful non-U.S.-tax economic impact or any substantial non-U.S.-tax purpose.

The Tax Court in Dover, discussed above, stated that the check-the-box regulations do not require any business purpose for an election to convert from corporate to disregarded entity status. The IRS apparently likewise does not insist on a business purpose for such an election. See PLR 201704003.

Does the liquidation through a check-the-box election, unlike an actual liquidation, prevent the IRS from utilizing the various judicial doctrines to deny a Section 334(a) step-up?

Unfortunately for the immigrant in this example, the check-the-box rules incorporate the step transaction and perhaps other doctrines described above in connection with an actual liquidation. As the Tax Court observed in Dover, and the IRS and stockholder in Dover acknowledged, Treas. Reg. Section 301.7701-3(g)(2)(i) provides that “[t]he tax treatment of a change in the classification of an entity for federal tax purposes by election . . . is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.”

In Revenue Ruling 2015-10 the IRS applied the step transaction rule in Treas. Reg. Section 301.7701-3(g)(2)(i). The IRS treated a transfer, by a C corporation to its subsidiary, of the interest in a single member LLC classified as a corporation, followed by a check-the-box corporation-to-ignored-entity election by that transferred LLC, as an asset transfer described in Section 368(a)(1)(D), even though, for state law purposes, the former-C-corporation-classified LLC was not liquidated.

The Tax Court in Dover observed, and the IRS and taxpayer agreed, that Treas. Reg. Section 301.7701-3(g)(2)(i) “is intended to ensure that the tax consequences of an elective change will be identical to the consequences that would have occurred if the taxpayer had actually taken the steps described.” In Tucker v. Commissioner, affirmed per curiam (5th Cir. 2019), cert. denied, the Tax Court, applying the governing Circuit’s pre-Section 7701(o)(1) formulation of the economic substance doctrine, denied U.S. income tax benefits from a tax-motivated transaction that included the acquisition of a shelf foreign entity with a corporate default classification, followed later that same month by a Treas. Reg. Section 301.7701-3(g)(1) foreign corporation liquidation election by that entity. The Tax Court stressed that the taxpayer never intended to conduct any legitimate business or investment activities through the foreign corporation.

Therefore, at least where the U.S.-tax-liquidated foreign corporation fails to provide a meaningful positive economic impact or a substantial non-U.S.-tax purpose, the IRS and Courts may well view AM 2021-002 as not offering any additional help to an immigrating non-citizen with respect to obtaining a Section 334(a) step-up through the use of a U.S.-tax-transitory corporation holding U.S.-tax-transitory title to her appreciated assets.

However, if the U.S.-disregarded foreign entity that continues to hold the pre-immigration assets has, after the non-citizen’s U.S. immigration, a meaningful positive economic impact and a substantial non-U.S.-tax purpose, unlike the U.S.-disregarded entity in Tucker, the immigrant may have a stronger case for avoiding adverse application of the Section 7701(o)(1) economic substance rule. Moreover, commentators have noted that the relationship of the step transaction doctrine to the economic substance doctrine is not clear, and that some courts may decline to apply the step transaction doctrine against a taxpayer who demonstrates economic substance. Compare Weikel v. Commissioner (where an individual’s transfer of assets to a newly formed corporation had a substantial independent business purpose, a transaction four months later divesting the individual’s control of that corporation, although contemplated at the time of the asset transfer, could not be treated by the IRS as part of an integrated step transaction). Therefore, one cannot rule out the possibility that a Section 334(a) asset step-up may be available from an incorporation, followed by a check-the-box U.S. tax liquidation of a continuing foreign entity, which entity, post-liquidation, demonstrates a meaningful positive economic impact and a substantial non-U.S.-tax purpose.

Conclusion

Even where the U.S.-tax-liquidated post-U.S.-immigration entity lacks a meaningful economic impact and a substantial non-U.S. tax purpose, there remains at least a superficial incongruity to the application of the step transaction and economic substance doctrines against a corporate formation, followed by a pre-immigration check-the-box liquidation in order to seek a Section 334(a) step-up. For purposes other than U.S. tax law, in contrast to U.S. tax purposes, neither the foreign corporation nor its ownership of the transferred assets is transitory. Rather, the foreign entity’s non-U.S.-tax legal existence and its non-U.S.-tax legal ownership of the transferred foreign assets are both permanent, not transitory. Yet Treas. Reg. Section 301.7701-3(g)(2)(i) and the step transaction doctrine apparently allows the IRS to ignore the foreign holding company as a transitory non-existent entity, so as to deny a Section 334(a) step-up.

Likewise, the entire concept of allowing a U.S. individual to make a check-the-box corporation-to-ignored-entity election is premised on allowing individuals the federal tax consequences of a Section 331 corporate liquidation, without triggering any economic consequences. Indeed, the Tax Court in Dover stated that the check-the-box regulations do not “require that the taxpayer have a business purpose for such an election [to convert from corporate to disregarded entity status].” Yet Treas. Reg. Section 301.7701-3(g)(2)(i) and Section 7701(o)(1) may allow the IRS to require the taxpayer to demonstrate that the transaction in which the check-the-box election plays a role has both a meaningful economic impact and a substantial non-U.S.-tax purpose.

However, such conflicts between the form-over-substance approach of the check-the-box rules, and the substance-over-form approach of the step transaction doctrine and Section 7701(o)(1), may be more apparent than real. The Tax Court in Dover concluded that the check-the-box rules do not require a business purpose to make an effective election to treat a corporate eligible entity as distributing its assets in liquidation. However, under Treas. Reg. Section 301.7701-3(g)(2)(i), the liquidating distribution from a check-the-box liquidation arguably need not be given federal income tax effect where the step transaction doctrine or Section 7701(o)(1) block such effect.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, FL.

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